New Subpart F Regs. Address Manufacturing Exception and Branch Rules

On December 29, 2008, Treasury published final, temporary,
and proposed regulations under Sec. 954 addressing the treatment
of contract manufacturing arrangements and the branch rules
applicable to foreign base company sales income (FBCSI), a type
of subpart F income applicable to the sale of inventory (T.D.
9438, REG-150066-08). The new regulations leave the original
regulations largely intact, provide an additional test for the
“manufacturing exception” (the substantial contribution test),
and provide a protocol for administering the branch rules. The
new regulations also eliminate the “its defense,” which is
described in the preamble as being contrary to existing law and
representing an incorrect reading of the FBCSI rules. These
regulations are generally effective for tax years of controlled
foreign corporations (CFCs) beginning after June 30, 2009, and
the corresponding tax years of U.S. shareholders.

In
general, the FBCSI rules impose U.S. tax on income derived by a
CFC in connection with the sale of products purchased from a
related party and sold outside the CFC’s country of organization
(Sec. 954(d)). Exceptions exist for products manufactured in the
CFC’s country of organization, de minimis transactions, and
transactions subject to high rates of foreign tax. An additional
exception exists for products that are manufactured by the CFC
(the manufacturing exception). In many cases, the selling CFC
may perform some but not all of the manufacturing functions in
connection with the property it sells. These new regulations
address the issue of what level of manufacturing activities a
CFC must perform to become eligible for the manufacturing
exception.

Two alternative tests are available under the
existing regulations to determine if a CFC has performed
sufficient manufacturing activities to satisfy the manufacturing
exception. The first is the substantial transformation test,
under which property is considered manufactured if it is
substantially transformed prior to sale. The regulations give as
illustrations of substantial transformation examples such as
converting wood pulp into paper, steel rods into screws and
bolts, and fresh fish into canned tuna (Regs. Sec. 1.954-
3(a)(4)(ii)). The second is the substantive test/safe harbor,
under which property is considered manufactured if the CFC
purchases components and performs substantial operations that
are generally considered to be manufacturing activities (Regs.
Sec. 1.954-3(a)(4)(iii)). A safe harbor is available if the
conversion costs (direct labor and factory burden) incurred by
the CFC in the integration process account for 20% or more of
the total cost of goods sold. Packaging, repackaging, labeling,
or minor assembly will in no event constitute manufacturing. The
new regulations refer to these two tests collectively as the
physical manufacturing tests.

Arguably, another basis for
claiming the manufacturing exception is available under the
statute, which provides that FBCSI is defined as “income . . .
derived in connection with the purchase of personal property
from . . . any person and its sale to a related person” (Sec.
954(d)(1); emphasis added). Taxpayers have taken the position,
commonly referred to as the “its defense,” that as long as the
property purchased and the property sold by the CFC is not the
same property, its sale does not give rise to FBCSI. CFCs
relying on this defense take and hold title to raw materials,
work in process, and finished goods inventories, while a related
third party performs the manufacturing processes on a contract
fee basis..

Branch Rules

The branch rules are
intended to prevent circumvention of the FBCSI rules by
taxpayers that conduct business through a branch, thereby
eliminating the intercompany sale that would otherwise give rise
to FBCSI.

Example: H is a CFC based in Hong
Kong, which in turn owns C, a manufacturing CFC based in the
People’s Republic of China (PRC). H purchases
products from C and resells them to customers outside Hong
Kong.

Such sales would give rise to FBCSI.
However, if C were instead structured as a branch of H (either
as a branch in fact or as a disregarded entity), the
intercompany sale of products from C to H would be a mere
transfer from a branch to the remainder of the CFC (remainder).
Absent the branch rules, FBCSI would be avoided. However, if the
branch rules apply, the branch is treated as a CFC separate from
the remainder, and the branch transfer becomes an intercompany
sale resulting in FBCSI.

The branch rules are triggered
based on the disparity in tax rates between the branch and the
remainder of the CFC. The manufacturing branch rule applies if
the sales or procurement function attributed to the remainder is
subject to tax at an effective rate that is less than 90% of,
and at least five percentage points less than, the tax rate that
would apply to that income if it were subject to tax in the
manufacturing branch’s home country (Regs. Sec. 1.954-
3(b)(1)(ii)(b)).

Returning to the example, if the effective
tax rate in Hong Kong is 17.5% and the effective tax rate in the
PRC is 25%, the Hong Kong rate is less than 90% of the PRC rate
(90% × 25% = 22.5%) and less than the PRC rate minus five
percentage points (25% – 5% = 20%). Accordingly, the
manufacturing branch rule applies.

Similarly, the sales
or procurement branch rule applies if the branch’s income is
subject to tax at an effective rate less than 90% of, and at
least five percentage points less than, the tax rate that would
apply to such income if it were subject to tax in the
remainder’s home country (Regs. Sec. 1.954-3(b)(1)(i)(b)). In
both tests, the branch rule is triggered by the sales or
procurement function being subject to a lesser tax rate than the
manufacturing function, with the presumption being that the
purpose of separating the relatively mobile sales or procurement
function from the relatively fixed manufacturing function is to
gain the advantage of the lower tax rate.

The branch
rules have grown increasingly unwieldy as a result of
globalization, segmentation of manufacturing practices, and the
proliferation of foreign branches resulting from U.S.
check-thebox elections. Today it is not uncommon for
multinational corporations to employ multiple manufacturing
facilities around the world, each manufacturing different
components or performing final product assembly and test
functions. At the same time, modern multinational corporations
employ procurement, sales, and distribution entities in many
countries. Checkthe-box elections are often made to treat some
or all of these entities as either disregarded entities or
branches of one or more foreign holding companies.

These
new and complex structures, which were not envisioned when the
original regulations were published, have raised important
questions with respect to the application of the branch rules.
For example, if multiple entities are involved in the
manufacture of a product, which entity is deemed to be the
manufacturer, and where is the location of manufacture? If a CFC
has multiple sales and manufacturing branches, how is the tax
rate disparity test administered? The new FBCSI regulations
attempt to address such issues.

New Regs.: Substantial
Contribution Test

If a CFC does not meet one of the
physical manufacturing tests, the new regulations provide a new
test, the substantial contribution test, whereby the CFC may
qualify for the manufacturing exception if it makes a
substantial contribution through the activities of its employees
to the manufacture, production, or construction of personal
property (Regs. Sec. 1.954-3(a)(4)(iv)).

Only the
activities performed by the CFC’s employees are considered. The
regulations provide a nonexclusive list of activities to be
considered in determining whether the substantial contribution
test is met based on the facts and circumstances:

Oversight and direction of manufacturing activities or
processes. Although the regulations single out this activity
as being important in most cases, the regulations qualify that
the performance of this activity may not be required in every
case, depending on the facts.

Activities
considered in, but insufficient to satisfy, the physical
manufacturing tests

Material selection, vendor
selection, or control of the raw materials, work in process,
or finished goods.

Management of manufacturing
costs or capacities. This includes activities that help ensure
that a plant is run in an economically efficient manner, such
as optimizing plant capacity, reducing waste, managing the
risk of loss, working on cost reduction or efficiency
initiatives associated with the manufacturing process, demand
planning, production scheduling, or hedging raw material
costs. Not all corporate managerial decisions are intended to
be considered in the test because many decisions are not
“directly related to the manufacture of the personal
property.”

Control of manufacturing-related
logistics. This includes, for example, arranging for delivery
of raw materials to a contract manufacturer but excludes, for
example, delivery of finished goods to a customer.

Quality control; for example, sample testing or
establishment of quality control standards

Developing, or directing the use or development of,
product design and design specifications, as well as trade
secrets, technology, or other intellectual property for the
purpose of manufacturing, producing, or constructing the
personal property. Only manufacturing- related activities are
considered.

The location of manufacture is
based on where the employees perform the activities, rather than
where the CFC is located. For this purpose, the definition of an
employee generally includes certain nonpayroll workers (such as
certain seconded workers, part-time workers, and contractors)
who are considered common-law employees under Regs. Sec.
31.3121(d)-1(c). The definition does not go so far as to include
anyone in an agency relationship, as this may create unintended
branch rule issues.

In connection with the substantial
contribution test analysis, all CFC employee functions that
contribute to the manufacture of the personal property are
considered in the aggregate and are weighted based on the
economic significance of such functions to the manufacturing
activities. The performance (or lack thereof) of any particular
activity is not determinative, and there is neither one activity
that must be performed in all cases nor any minimum number of
activities or a performance threshold (Regs. Sec.
1.954-3(a)(4)(iv)(c)). (Note that eleven examples in the
regulations in which the test is satisfied involve at least
three, and often four, of the factors listed above.)

The
fact that other persons make a substantial contribution to the
manufacturing activities does not preclude the CFC from making a
substantial contribution of the same activities through its
employees. Therefore, in applying the test, each CFC takes into
account its own employees’ individual activities, considers all
functions performed by the employees, and weights the functions
based on the facts and circumstances of the particular business
in order to determine if sufficient activity has been
performed.

The mere right to perform these activities is
not sufficient; the CFC’s employees must actually exercise their
right and perform the activities. Thus, contractual rights,
legal title, tax ownership, or assumption of economic risk are
not determinative. The substantial contribution test is
administered on a productby- product basis. For this purpose, a
product is defined by reference to the distinctions made by the
CFC in its business operations and in its books and records, not
by a third-party definition or industry classification (e.g.,
SIC code). There is no special documentation required in
connection with the substantial contribution test.

New
Branch Rules

The new regulations provide a protocol for
applying the branch rules to modern multinational business
models. This protocol may be best addressed by way of a summary
of its principles:

Each branch’s functions
stand on their own for purposes of determining if a
manufacturing test is met. (An exception applies to multiple
branches in the same country, which are considered in
aggregate.)

The location of a manufacturing
activity is determined based on where employees perform such
activity

The functions of branches not treated
as separate CFCs under the tax rate disparity tests are
attributed back to the remainder.

The
hypothetical effective tax rate, for purposes of the tax rate
disparity test, takes into account any uniformly available tax
incentives available in the foreign jurisdiction.

In a case in which sales, procurement, and manufacturing
functions are performed through branches (e.g., the remainder
is a pure holding company), the tax rate disparity test is
applied on a branch-to-branch basis.

In a case
in which sales, procurement, and manufacturing functions are
performed through branches (e.g., the remainder is a pure
holding company), the tax rate disparity test is applied on a
branch-to-branch basis.

If the CFC as a whole is
determined to satisfy the substantial contribution test, but
no branch individually satisfies a manufacturing test, the
manufacturing location is determined using an approach that
employs both a functional analysis and a comparison of
effective tax rates.

Effective Date

These regulations are generally effective for tax years of
CFCs beginning after June 30, 2009, and for tax years of U.S.
shareholders in which or with which such tax years of the CFC
end (e.g., 2010 for calendar-year taxpayers). Taxpayers may
elect retroactive application to all open tax years, and the
regulations expire in three years.

Conclusion

The new FBCSI regulations largely succeed in updating the
regulations to address modern business models. The new
substantial contribution test provides a welcome third
alternative to the existing physical manufacturing tests. The
revised branch rules also provide a greater degree of clarity
and certainty, albeit at the cost of additional complexity.
Taxpayers that may be adversely affected by these regulations
include those that have relied on the “its defense” and those
employing foreign holding company/check-thebox structures. All
taxpayers involved in cross-border trade should revisit their
structures in light of these new regulations and be mindful of
permanent establishment, transfer pricing, and other foreign
implications arising from any operating modifications made to
comply with the new regulations.

EditorNotes

Mindy Cozewith is director, National Tax, at RSM McGladrey,
Inc., in New York City.

Unless otherwise noted, contributors are members of or
associated with RSM McGladrey, Inc.

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